Proposed regulations simplify IRC Sec. 338 rules. (Federal Taxation)

by Jacobini, Susan

Abstract- The IRS has proposed regulations that would simplify and limit the reach of consistency rules under IRC Sec. 338(e) by terminating the theoretical groundwork of the existing directives on consistency. The asset consistency regulation being tendered is aimed at preventing the structuring of acquisitions that allows exploitation of the Reg. Sec. 1.1502-32, or the consolidated return investment adjustment rules. Under the proferred statute, the consistency rules would only apply if the company being acquired is a part of a consolidated return of the group selling it. It also requires carryover basis in an acquired asset if the asset is transferred within the target consistency timeframe, the basis of the target stock is indicative of gain from the disposition of the asset and the asset is held by a company that buys the target stock in the qualified stock purchase. Anti-avoidance provisions to avert circumvention of the consistency rules are also included.

Existing IRC Sec. 338 Rules

When a corporation purchases a target corporation in a qualified stock
purchase, the purchasing corporation may elect to treat the purchase as
an asset acquisition under IRC Sec. 338(g). The target is treated as if
it sold its assets in a single transaction, and then repurchased those
assets as a new corporation. This results in the taxation of any built-
in gain on the assets. Unless the target has significant net operating
losses available to shelter the deemed-sale gain, it is generally not
desirable to affirmatively elect asset sale treatment under IRC Sec.
338(g) since there are two levels of gain--gain to the seller on the
actual sale of the stock and gain to the buyer on the deemed sale.

However, there are several circumstances where an IRC Sec. 338(g)
election coupled with an IRC Sec. 338(h)(10) election still renders
favorable tax consequences. If the latter election is made, the deemed
sale by old target occurs while target is still a member of the seller's
consolidated return followed by a tax-free liquidation of old target
into its parent under IRC Sec. 332. The purchasing corporation is
treated as having purchased target with a stepped-up basis in its
assets. If the selling consolidated group has NOLs or other tax
attributes to shelter the deemed-sale gain, the assets of target are
stepped-up without a tax cost. Even if there were no tax attributes
available to shelter the gain, only one level of tax is paid in the
transaction. Under this scenario, the cost of the step-up would be
weighed against the present value of the future depreciation and
amortization deductions attributable to the step-up. The sales price of
the stock would theoretically be adjusted to reflect any increased tax
cost to the seller as a result of the deemed sale. If the outside basis
of the target stock were lower than the inside basis of the target
assets, the deemed asset sale would yield a lower tax gain to the
seller. This should also be considered in the analysis.

IRC Sec. 338(e) provides consistency rules to prevent the purchasing
corporation from selectively acquiring certain assets from a target or
target affiliate in a direct purchase, for the purpose of obtaining a
stepped-up cost basis in these assets, while acquiring other assets and
tax attributes through a stock acquisition, not involving an IRC Sec.
338 election, and obtaining a carryover basis in those assets. The
consistency period is the 12-month period preceding the date on which
the stock is purchased and the 12-month period after the stock purchase
date. The consistency rules have their genesis in pre-TEFRA law. Under
old IRC Sec. 334(b)(2), a purchasing corporation could purchase Target 1
and Target 2 and obtain a step-up basis in Target 1 by liquidating
Target 1 while retaining historical basis in the assets of Target 2 by
not liquidating. The Treasury viewed this type of selectivity as
abusive. Stock consistency rules were incorporated into the IRC Sec. 338
to address this concern.

A similar abusive result was thought to occur when there was the
purchase of an asset contemporaneous with a qualified stock purchase,
and this was reflected in the drafting of the temporary relations. These
type of transactions became known as "tainted asset acquisitions."
Certain asset acquisitions made in the ordinary course of business or
assets acquired by a purchaser that would not result in a stepped-up
basis in the hands of the purchaser are excepted from the consistency
rules and will not result in a tainted asset acquisition.

Three Choices

In any asset acquisition (and the concurrent purchase of the stock of a
target corporation), the taxpayer has three choices. It can 1) do
nothing, 2) make a "protective carryover basis election", or, 3) make an
IRC Sec. 338 election for target.

If no action is taken, alternative 1, all assets acquired from the
seller take a carryover basis, and the target stock retains historic
attributes and basis. Under alternative 1, the district director may on
audit impose a deemed IRC Sec. 338 election. This would result in the
stock acquisition being treated as an asset acquisition, with all the
gain on the assets recognized. But assets acquired in the tainted asset
acquisition would have a stepped-up basis. This IRS discretion will
probably never be exercised in favor of the taxpayer. Alternative 2
precludes an IRC Sec. 338 election (and the resulting recognition of all
gain to target). The trade-off is that the purchaser receives a
carryover basis in the tainted assets acquired. Alternative 2 is
appropriate when the detriment of carryover basis on the tainted assets
is small compared to the benefit obtained by avoiding the recognition of
substantial gains on an IRC Sec. 338 election. Alternative 3 is
appropriate when the need for a cost basis on the tainted asset
acquisition is substantial compared to the small detriment to the
taxpayer making an IRC Sec. 338 election and recognizing gain on the
target assets.

Applying consistency rules became a complex matter for many taxpayers
and practitioners alike, especially when consolidated return regulations
impact certain post-acquisition asset goals. This complexity is
especially perplexing since after the General Utilities repeal, the
consistency rules no longer serve their intended purpose which was to
prevent taxpayers from engaging in transactions designed selectively to
obtain tax benefits then available without the associated tax cost.

Proposed Changes

The IRS has issued proposed regulations under IRC Sec. 338 which are not
effective until finalized. Until the regulations are issued in final
form, the rules under the existing temporary regulations remain in force
with all the attendant consequences discussed above. The proposed
regulations, when effective, would simplify and narrow the scope of
consistency rules under IRC Sec. 338(e) by abandoning the theoretical
underpinning of the old consistency rules. The sole purpose of the new
asset consistency rules is to prevent acquisitions from being structured
to take advantage of the consolidated return investment adjustment rules
(Reg. Sec. 1.1502-32).

Under the proposed regulations, the consistency rules generally apply
only if the target is a member of a consolidated return of the selling
group. The District Director and Commissioner's discretion in applying
the consistency rules and the affirmative action carryover, protective
carryover, offset prohibition, and regular exclusion elections are
eliminated.

Generally, the new consistency rules operate to require carryover basis
in an acquired asset if--

* The asset is disposed of during the target consistency period;

* The basis of the target stock reflects gain from the disposition of
the asset; and

* The asset is owned, immediately after its acquisition and on the
target acquisition date, by a corporation that acquires stock of target
in the qualified stock purchase (or by an affiliate of an acquiring
corporation).

The carryover-basis rules generally apply to direct acquisitions of
assets from target, a subsidiary in a consolidated group, by the
purchaser (or an affiliate), during the consistency period. The rules
also apply to assets acquired from lower-tier target affiliates or
certain conduits if gain from the sale is reflected in the basis of the
target stock. Thus, if the seller receives a step-up in the basis of T
stock, an automatic carryover basis rule applies to the asset purchase
unless P makes an IRC Sec. 338 election. This ensures that someone pays
the tax on the step-up. A de minimis exception applies to prevent the
automatic carryover-basis rule from applying in the case of a tainted-
asset acquisition of less than $250,000.

Apparently, the carryover basis rule only applies in situations where
the consolidated investment adjustment rules afford a benefit to the
seller. If the purchaser acquires target and causes target to sell the
asset to a member of the purchasing group, the purchasing member
obtained a cost basis in the assets. Presumably it has been conceded
that "anti-mirror" rules which were added to the consolidated return
regulations after TRA 86 has solved the abuses perceived under the
former set of consistency rules. The new regulations also adopt anti-
avoidance rules to prevent circumvention of the consistency rules.

Of special significance is the repeal of the stock consistency rules.
The new regulations allow the purchasing corporation to make an election
under IRC Sec. 338 for target without being deemed to have made the
election for any target affiliate. However, the stock consistency rules
would still apply to prevent asset inconsistency under the new regime.

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